Morgan Stanley positioned for Fed-fueled liftoff

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Morgan Stanley is positioned for a liftoff – but timing is in the hands of the U.S. Federal Reserve. Solid trading and cost cuts left the Wall Street bank earning $1.5 billion, 62 percent higher than the same period last year. That put annualized return on equity just shy of 9 percent, the lower end of Chief Executive James Gorman’s target for 2017. Some help from America’s central-bank-cum-industry regulator could boost the ROE towards 11 percent, a figure that would rival Goldman Sachs.

The Fed could, for one thing, raise interest rates. That would add extra juice to Morgan Stanley’s relatively new lending unit within its global wealth management division. It has some $150 billion of customer deposits, but has so far lent out less than half that amount – though it grew at a fast clip of 26 percent compared to last year’s third quarter.

A bigger boost would come if the Fed allows Gorman’s firm to buy back more stock. Morgan Stanley is currently one of the best capitalized banks, with a common equity Tier 1 ratio of equity to risk-weighted assets of 15.9 percent by the most up-to-date standards. That compares to 13.4 percent at Goldman. Were Morgan Stanley able to pay out capital and reduce its ratio to that level, its annualized ROE last quarter would have been as high as 10.6 percent.

That won’t, though, happen just yet. The largest banks are still waiting to find out what the implications are of newly defined capital buffers outlined last month by Fed Governor Daniel Tarullo. The changes are not due to take effect until next year, meaning lenders won’t be able to factor it into capital-return plans until the Fed runs its 2018 stress tests.

In the meantime, shareholders can feel some confidence that Morgan Stanley’s progress is sustainable, markets permitting. The improved performance of the fixed-income division is of particular note. Revenue jumped 157 percent, excluding accounting gains in last year’s third quarter, even though the unit has undergone a significant restructuring since then, including laying off a quarter of its staff.

The bank, with a market capitalization of $63 billion, has cranked up its ability to generate extra revenue with its existing resources, with the top line in the third quarter rising 15 percent from a year earlier while expenses notched up by just 4 percent. Gorman has runway to deliver stronger returns – but he still needs the all-clear from the Fed.